Choose corporate debt over stocks, say managers

It's exactly the wrong time to rebalance portfolios, says bond expert

By

SamMamudi

NEW YORK (MarketWatch) -- Falling stock prices this year have left many investors' portfolio balances out of whack. But some managers argue against the need to rebalance holdings.

Mark Kiesel, executive vice president at bond-fund giant Pimco, a unit of Allianz
AZ, -2.24%
believes the relative values of high-grade corporate debt compared with stocks means that selling bonds and buying stocks would be a big mistake, he said.

"We're in a unique situation where you can get 8% to 10% returns in high-quality corporate bonds, while stock returns are unlikely to do that for the next couple of years," said Kiesel. "If I asked you, 'Do you want 8% to 10% or 5% [from stocks], with three times the volatility,' which would you want?"

"You won't see prices go up tenfold with bonds, but today you can double your money," said Kevin Murphy, team leader of the high-grade corporate and emerging markets debt team at Putnam Investments.

Kiesel argued that because the downturn was triggered by credit problems, investors shouldn't worry about missing out on stock gains until there's an upturn in the credit market.

"There will come a time when it's good to buy stocks, but you need the credit markets to heal first," he said.

The attraction in high-grade corporate debt, said Kiesel, is that the market has priced in greater risk than it faces. "These are the widest spreads versus Treasurys we've seen in 75 years," he said. While he said he expects the 0.3% default rate to rise to about 1%, the market is pricing in a 5% default rate.

Corporate bonds rated BBB or better yielded about 6.8 percentage points more than Treasurys on Dec. 23, according to an index compiled by Merrill Lynch. The spreads are almost as attractive among the top-tier bonds: In the category of A-rated or higher-rated corporate debt, the yield is 5.51 percentage points better than that of Treasurys.

Reviewing allocations

The urge to rebalance comes after a year that has seen the broad Standard & Poor's 500 lose about 40% of its value. Because bond values have held up better than stocks have, a balanced portfolio with the typical 60%-40% split between stocks and bonds will now be tilted more in favor of bonds. If investors followed the traditional advice, they'd be looking to cash out of bonds to buy stocks to restore that balance.

But Murphy said high-grade corporate bonds are "at least as attractive" as stocks right now. He pointed out that corporate-bond yields are much higher than stocks' dividend yields.

"The arguments supporting bonds are much stronger now than they were a year or two ago," said Murphy. "Bonds should be more than the 40% in a portfolio."

While Murphy was more guarded in his enthusiasm than Kiesel, he agreed that bonds are priced more realistically than stocks.

'This is the first real test in a long time of peoples' risk tolerance, and many have learned that their asset allocation was too risky for them.'
Tom Idzorek, Ibbotson Associates

"There's a case to be made that corporate-bond spreads have priced in a more pronounced and longer downtown than stock prices, if you go on stock's price-to-earnings ratios," said Murphy. "And you could even question the profit estimates that those P/E ratios are based on."

"I'm not arguing that the economy isn't very weak, but in this asset class you're getting paid for the risk," said Kiesel.

But even though high-grade corporates are more attractive than stocks right now, for the average investor making that bet may be unwarranted.

"Maybe it is a good time to invest in high-grade corporate bonds," said Tom Idzorek, chief investment officer at Ibbotson Associates, an investment-advisory unit of Morningstar Inc. "But the vast majority of investors should not engage in market timing. There's very little evidence that even successful money managers can make these timely calls."

Kiesel said that, by historical standards, it can be argued that stocks haven't bottomed. In past downturns, he said, stocks bottomed at about seven times earnings. The comparable current level for stocks is about 10.5 times earnings.

"On a relative basis, high-quality corporate bonds are likely to outperform equities over the near term," he said.

Idzorek, though, maintained that investors should "stick to strategic asset allocations" and keep the same balance. He argued for this even if it means rebalancing now, when market conditions may be unfavorable. "It's kind of a contrarian style," he admitted.

But that doesn't mean investors shouldn't rethink their long-term allocations, and possibly take the opportunity to increase their bond holdings.

"This is the first real test in a long time of peoples' risk tolerance, and many have learned that their asset allocation was too risky for them," said Idzorek. "If you have been scared to the sidelines, then you were in the wrong asset allocation."

Top quality

For those who found their allocation too risky and want to add bonds, Murphy said the focus should be in the top tier of high-grade debt. "The A-rated and BBB+ spreads are wide enough; there's no need to take on extra risk," he said.

Murphy added that, even in a credit crunch as bad as this year's, the highest-quality names can still sell debt -- companies such as Procter & Gamble Co.
PG, -0.40%
Caterpillar Inc.
CAT, -0.86%
and McDonald's Corp.
MCD, -0.64%
can always come to market, and are therefore very appealing. "You want to be in a liquid, well-known name," he said.

Pimco's Kiesel said he's looking at AA- and A-rated banks, as well as noncyclical sectors such as utilities, pipelines, health care, and cable and telecom.

"This is a once-in-20-years opportunity to load the boat on this stuff," he said.

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